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Central Banking, Liquidity Risk, and Financial Stability, Lecture, Summer 2009, Technical University of Berlin, Ulrich Bindseil, European Central Bank

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Central Banking, Liquidity Risk, and Financial Stability, Lecture, Summer 2009, Technical University of Berlin, Ulrich Bindseil, European Central Bank Central banking, liquidity risk, and financial stability, Lecture, Summer 2009, Technical University of Berlin, Ulrich Bindseil, European Central Bank 2. An overview of financial crises and the role of liquidity and central banks A. Large asset value losses ............................................................................................1 B. Declines in asset values create capital constraints and increases default probability of financial institutions ..................................................................................................9 C Spill over into a liquidity crisis ................................................................................12 D. Credit crunch: reduced lending to the real sector ...................................................18 E. Mapping the financial system into accounts ...........................................................20 F. Wrap up questions ...................................................................................................23 We will try to gain an overview of financial crisis. What is causing them? What is a liquidity crisis? What phases can typically be observed? And what can cure a crisis? From the start, we will focus in particular on the liquidity dimension of crises, as this is where the central bank will be supposed to play a major role. We get inspiration from some 19th century literature (e.g. Bagehot). If features described long time ago still appear to apply today, we may want to believe that they must be quite general. A. Large asset value losses E.g. Bagehot (1873), Wirth (1883), or Kindleberger and Aliber (2005) all highlight the key role as a trigger for most financial crisis of a serious downward revision of asset values and of the general perception of the worth of projects and the general economic prospects. The starting point of this downwards revision is often linked to what is considered ex post to be an asset bubble, relying on an overestimation of some innovation plus a general trading hype. In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a non-fundamental bubble component that may reflect price speculation or irrational investor euphoria or depression. The expansion of an asset price bubble may lead to misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy. Of course, asset values can also crash on the basis of substantial fundamental bad news, and this can also suffice to trigger a financial crisis. A few examples In the current turmoil, the break of a trend in real estate prices plays a key role. The following chart on UK housing prices (BoE financial stability review of November 2008) suggests that in 2007, a long term exceptional upwards trend in house prices ended. The second chart, which is due to Paul Krugman (11 October 2008, NY Times blog), suggests a dual asset price bubble burst for the US: 1 Also the unprecedented “L-shaped” Japanese stagnation ever since 1990 was the result of an unprecedented real estate and equity bubble. Real assets affect the value of financial assets that are linked to those real assets. In the case of the current crisis, securities relating to mortgages were unsurprisingly particularly hit. The following table provides losses as estimated in October 2008 of debt securities values (IMF, 2008, 15): In January 2009, the IMF provided an update with a total loss estimate of USD 2.2 trillion (instead of the USD 1.4 trillion in the table above). For the most hit asset class, ABS containing sub-prime mortgages, the chart below provides an idea of the extent of losses, according to rating grades (table from: M.K. Brunnermeier, 2009, “Deciphering the liquidity and credit crunch, 2007-08”, working paper, Princeton). 2 The losses on fixed income securities are of course only one part of the financial asset value losses. Global stock markets would have lost about $28.7 trillion in 2008 (around 40% of their value), exceeding by far the estimates on fixed income assets losses (although relatively more attention has been given to fixed income assets maybe because the banks’ share of holdings of stocks is lower, and hence financial stability consequences are more moderate?). Bubbles burst because investors realise they over-estimated asset values Already Bagehot (Chapter 6), mocks about the absurd projects which were promoted and believed at the occasion of the South Sea Bubble of 1720, but that necessarily must have lead to a crash as soon as investors became realistic again: “But, in fact, in the South Sea Bubble, which has always been remembered, the form was the same, only a little more extravagant; the companies in that mania were for objects such as these:' "Wrecks to be fished for on the Irish Coast—Insurance of Horses and other Cattle (two millions)—Insurance of Losses by Servants—To make Salt Water Fresh—For building of Hospitals for Bastard Children—For building of Ships against Pirates—…—For extracting of Silver from Lead—…For a Wheel of Perpetual Motion." But the most strange of all, perhaps, was "For an Undertaking which shall in due time be revealed." Each subscriber was to pay down two guineas, and hereafter to receive a share of one hundred, with a disclosure of the object; and so tempting was the offer, that 1,000 of these subscriptions were paid the same morning, with which the projector went off in the afternoon.' In 1825 there were speculations in companies nearly as wild, and just before 1866 there were some of a like nature, though not equally extravagant..” This account contains several key aspects described again and again to hold for financial crisis built-ups: overestimation of projects or of the general economic prospects, leading to too high asset values, speculative mania, and market price dynamics. 3 Similar recent cases of asset bubbles which were mainly driven by overly optimistic assumptions on the fundamental value of projects were • The German Third Generation cell phone auctions in 2000 in which EUR 105 billion were achieved as auction proceed, but the six winning companies realising soon that they had hugely overpaid the licences, or the • general dotcom-boom, as exemplified in Germany by the Neuer Markt. Its index, the Nemax, stood in March 2000 at 9666 points, and in October 2002 at 318 points, achieving an impressive minus of 96%. A comprehensive statistical overview of housing and equity market bear markets in industrial countries is provided by T. Helbing and M. Terrones (2003, “When bubbles burst”, World Economic Outlook, IMF, April 2003, Chapter II). Irrational exuberance or rational uncertainty? Why do intelligent professionals overestimate (from an ex post perspective) the value of projects? Two possible answers: • Irrational exuberance: Investors become collectively irrational at some stage, and also through the game of the market (be it the stock exchange or an UMTS auction) bid each other up. Maybe some or even a relevant share of individuals realise that prices are overstated, but they still play the game because as long as it continues, it appears profitable (but people appear naively to believe that they all can get out in time?). • Rational uncertainty: even if thinking carefully, it is not clear ex ante to distinguish the good from the bad project (and hence the overvalued from the fairly valued asset). Hence, ex post critique would be rather cheap and irrelevant. This view relates to the efficient market hypothesis that markets aggregate existing information in an efficient way. According to an ECB monthly bulletin article of 2005, it is on one side hard to find strong systematic evidence in favour of the irrationality hypothesis, while on the other side from an ex post perspective it is easy to find episodes in which "valuation indicators were clearly out-of-line with respect to their long term averages" (p. 51). Supporting the “rational uncertainty” theory, it may be noted that for a fixed asset with a duration of cash-flows of 20 years, a change in the (rationally) assumed growth rates of cash flows can indeed be quite dramatic. When markets grow very quickly, as it can be assumed for new pervasive technologies, a change of expectations from e.g. 20% to 5% has a dramatic effect, as summarised in the example of the following table. 4 Assumed Net present value of project growth (cash flow in Y1 = 100 rates of discount rate = 5% cash flow 20 years horizon) 5,0% 2.000 7,5% 2.524 10,0% 3.225 12,5% 4.164 15,0% 5.427 17,5% 7.126 20,0% 9.414 Take the following two famous examples from the former Fed-Chairman Greenspan, who reveal him to be more of a believer in the “rational uncertainty” school. First, consider his “irrational exuberance” comment, which triggered a temporary slump in stock prices, was made on December 5, 1996: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? [...] ” He took this question up in more detail in another speech on September 4, 1998, entitled: “Question: Is There a New Economy?” “The question posed for this lecture of whether there is a new economy reaches beyond the obvious: Our economy, of course, is changing everyday, and in that sense it is always "new." The deeper question is whether there has been a profound and fundamental alteration in the way our economy works that creates discontinuity from the past and promises a significantly higher path of growth than we have experienced in recent decades. The question has arisen because the economic performance of the United States in the past five years has in certain respects been unprecedented…. Some of those who advocate a "new economy" attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world's producers on a more lasting basis.
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